Investing in dividend stocks can provide steady cash flow and appreciation without the hassle of owning real estate or settling for the lower yields and returns of more conservative investments. The income from dividend stocks may even cover living expenses and make an investor’s retirement years more financially stable.
Although dividend stocks are known for assisting with long-term goals, every investment has risks. While so-called dividend aristocrats have increased their dividends for 25 consecutive years or more, other companies have cut their dividends and gone out of business. Even if a company stays in business, a dividend cut can hurt retirees who rely on it for income.
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Knowing how to analyze a stock’s dividend can reveal opportunities and keep you away from risky investments with limited upside. A dividend-stock analysis goes beyond the current yield and stock price.
Spending some time analyzing a stock’s dividend before making a pick can help keep your long-term financial goals on track. You can follow these steps to determine whether a particular dividend stock fits into your overall financial plan:
— Clarify your long-term investment goals.
— Know your dividend investing type.
— Check the dividend payout ratio.
— Monitor the dividend payment history.
— AT&T stock dividend cut: An unsustainable payout.
— Review year-over-year revenue and earnings growth.
— Assess the stock valuation.
Clarify Your Long-Term Investment Goals
Before analyzing any stock and its dividend, investors should make sure they’re clear on their portfolio objectives. Walking into any investment without knowing how it aligns with your long-term horizon can hurt your portfolio.
Matt Mondoux, senior financial advisor at Blue Chip Partners, suggests that dividend investors focus on cash flow. “The aim should be to create a portfolio that pays enough dividends to fund living expenses in retirement. If the lion’s share of an investor’s living expenses is met by dividends, then they will not need to rely on selling shares of stock to fund their lifestyle.”
[READ: Best Dividend ETFs to Buy Now.]
Know Your Dividend Investing Type
When it comes to dividends, most investors fall under one of two categories: income or growth. Dividend income investors value cash flow over appreciation and growth rates. These investors look for dividend stocks with high yields. Share price appreciation is a nice bonus, but the current dividend is the main focus.
AT&T Inc. (ticker: T) and Verizon Communications Inc. (VZ), for example, are stocks chosen for dividend income investing. These stocks have high dividend yields (VZ’s is 6.9% now), but the underlying businesses have low-single-digit revenue growth.
Dividend growth investors focus on appreciation and growth rates over yield. Stocks in this category have lower yields but more room for the dividend to grow.
Apple Inc. (AAPL) and Broadcom Inc. (AVGO) are examples of dividend growth stocks. These companies have lower dividend yields (Apple’s is 0.55%) but have generated higher returns than AT&T and Verizon over the past 10 years, if you include price appreciation.
Once you know what you want as an investor, it’s easier to analyze a stock and know how it may fit in your portfolio. Establishing criteria, as Mondoux explains, also eliminates many stocks from your buy list.
“Limiting the pond in which you fish from is another great way to avoid the ‘soup du jour’ investment that likely does not align with your goals,” he says.
Check the Dividend Payout Ratio
Corporations are not obligated to reward shareholders with dividends every quarter. However, investors begin to expect dividends once a company starts giving them out.
Corporations can lose a lot of investors if they stop the dividend, so most companies continue paying dividends if they can. While a significant global or economic event can result in a dividend cut that surprises investors, other cuts are easier to predict.
Investors can look at a company’s dividend payout ratio and dividend history to gauge a dividend’s sustainability. The dividend payout ratio measures the percentage of a company’s earnings that get distributed as dividends.
“Dividends don’t lie. You can’t make them up. It’s not some accounting trick.” – Hank Smith, head of investment strategy at Haverford Trust Co.
You can calculate this ratio by dividing the annual dividend per share by the annual earnings per share. So, for example, if a company has an annual dividend per share of $2 and an annual EPS of $5, the dividend payout ratio is 40%.
A 40% payout ratio suggests that the dividend is sustainable. “When you start getting above 70% of the earnings going to the dividend, one has to do some extra analysis to make sure that the dividend is safe,” says Hank Smith, head of investment strategy at Haverford Trust Co.
Keep in mind that dividend payouts are best compared within specific industries and investment types, as they can vary significantly. Master limited partnerships, or MLPs, for example, often have comparatively high payouts, as do real estate investment trusts, or REITs.
As part of the extra stock analysis, Smith suggests looking at the company’s cash flow and seeing if the company has a decline in business fundamentals that is more than just a temporary setback.
[SEE: 7 Dividend Stocks to Buy and Hold Forever]
Monitor the Dividend Payment History
An effective stock analysis combines multiple components instead of relying on one indicator. As useful as the payout ratio is, it’s important to incorporate other details, like a company’s dividend payment history.
Dividend payment history reveals how often a company pays dividends and how much it raises the dividend. Most corporations increase their dividend each year to reward shareholders and indicate confidence in the business. Some companies in growth mode with strong financials can afford to hike their dividend by more than 10% each year, while other companies have lower growth rates.
Smith views dividend hikes as a critical component of analyzing dividend stocks. “When companies increase their dividend, that is the most tangible statement they can make about their confidence in the current and future fundamentals of their companies,” he says. “Dividends don’t lie. You can’t make them up. It’s not some accounting trick.”
AT&T Stock Dividend Cut: An Unsustainable Payout
If a company suddenly stops raising the dividend, the dividend may be unsustainable.
AT&T is one of many examples of a company that had shaky dividend growth right before running into obstacles. The former dividend aristocrat recently cut its payout by almost half in 2022, a year after it paused its annual dividend increases.
AT&T had warning signs of an unsustainable dividend before the company announced the dividend cut. Declining earnings, a high payout ratio and unprofitable acquisitions were some of the company’s troubles.
The stock’s high yield enticed income investors, but the fundamentals finally caught up with the company.
AT&T’s first-quarter earnings announcement in 2023 presented more pain, as the company revealed it did not generate enough free cash flow to keep up with the already-reduced dividend. The earnings sell-off increased AT&T’s yield, but the market may also be signaling a lack of confidence in AT&T’s ability to maintain the dividend. A high yield doesn’t always lead to a high return.
Review Year-Over-Year Revenue and Earnings Growth
A company’s growth over the years offers clues about a dividend’s stability. Past results do not guarantee future success, but they tip investors off as to the company’s direction. Dividend stocks can continue rewarding shareholders if the underlying company has positive revenue and earnings growth. A company that can consistently grow revenue and earnings by over 10% each year usually has enough room to grow and support the dividend.
Companies with decelerating year-over-year revenue and earnings growth may be at risk to dividend cuts in the future. If a company grew earnings by 20% year over year three years ago and only reported 5% year-over-year growth in its recent earnings report, it’s worth checking to see if the dividend may soon be at risk.
A company like Intel Corp. (INTC) demonstrates how decelerating revenue and earnings growth can eventually hurt the dividend and the share price. Here are the revenue and earnings growth rates for Intel from 2018 to 2022:
| Year | Intel revenue | Net income |
| 2018 | $70.8 billion | $21.1 billion |
| 2019 | $72 billion (+1.69% year over year) | $21 billion (-0.47% YOY) |
| 2020 | $77.9 billion (+8.19% YOY) | $20.9 billion (-0.48% YOY) |
| 2021 | $79 billion (+1.41% YOY) | $19.9 billion (-4.78% YOY) |
| 2022 | $63 billion (-20.25% YOY) | $8 billion (-59.8% YOY) |
After a dividend hiatus from 2003 to 2013, Intel brought its payout back in 2014. During that year, Intel achieved 6% year-over-year revenue growth and 22% year-over-year growth in net income. Those numbers painted the picture of a sustainable dividend, but they didn’t last. Intel’s net income has steadily declined since 2018 and put pressure on the payout, leading the company to slash its annual dividend by 66%, to 50 cents, in February 2023. Intel’s dividend yield is now 1.6%.
Assess the Stock Valuation
After reviewing the company’s and the dividend’s sustainability, the final step is to look at the valuation. Some dividend stocks have enticing growth rates and high yields that get overshadowed by a lofty valuation.
Investors can use many valuation metrics to assess a stock’s intrinsic value, but most dividend investors focus on the price-earnings ratio. You can arrive at the P/E ratio by dividing the share price by earnings per share.
If a company trades at $100 per share and reports an annual EPS of $4, the stock trades at a P/E ratio of 25, or 25 times earnings. If you like the stock but believe it’s overvalued, you can establish a fair price point to buy shares. Investors who believe a P/E ratio of 20 is more reasonable for $4 EPS will have to wait for the stock to trade at $80 or below before buying shares.
When looking at the P/E ratio or any other valuation metric, it’s important to compare the right companies. Using a tech company to gauge if a bank stock is fairly valued can lead to the wrong conclusion since those companies operate in different industries.
Investors use valuations to determine if a company is fairly valued, but that doesn’t tell you how an investment will change in the future. Monitoring a company’s fundamentals can help you determine the stock’s long-term potential.
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How to Analyze a Stock’s Dividend originally appeared on usnews.com
